Forfaiting transactions are complex and not well understood, they are easily confused with other, similar, transactions. The knowledge of how to conduct these transactions is held by few individuals within a small number of financial institutions, and as a result it is not widely available.
Forfaiting specifically addresses cross boarder trade and was designed to facilitate the export of goods to emerging markets and OECD markets. It involves an exporter that wishes to ship goods and an importer that wishes to receive them. The exporter agrees to deferred payment terms, and the importer arranges a deferred payment (aka ‘usance’ in Asia) letter of credit with a local issuing bank. The letter of credit will expire unless the goods are delivered by its expiry date. If the goods are delivered the letter of credit may be cashed at its maturity date. The local issuing bank seeks payment from the importer.
After delivery, provided the shipping documents are accepted as in compliance with the terms of the letter of credit, and the obligation to pay is accepted or issued by the L/C issuing ‘opening’ bank, then the exporter has a negotiable instrument that is a trade receivable in the form of a draft, promissory note or other form of documenting a payment obligation which can be held by the exporter until maturity or can be discounted prior to maturity.
An exporter that seeks payment prior to the maturity of the obligation, may sell the obligation say, to a bank or other purchaser or investor, for its net present value. The sale is ‘without recourse’ which means that the new owner does not look to the exporter or any subsequent holder or seller for payment in the case of default, but rather to the L/C issuing ‘opening’ bank as obligor or guarantor, and to the primary purchaser as the party is responsible for having done enough due diligence to ascertain if the obligation is or is not fraudulent. Since the beneficiary of the letter of credit is the exporter, the ownership of the payment obligation must be transferred properly. This usually includes the execution of an acceptance or acknowledgment of the assignment of the underlying obligation by the LIC issuing ‘opening’ bank or other form of obligor (usually the initial guarantor), the exporter and the new purchaser/holder/owner. The new purchaser/holder/owner can subsequently sell the instrument again, and this may create for them an opportunity to generate profit often via an arbitrage based on geographic or other market differences in perspective.
The negotiable instrument is the draft or other form documenting the payment obligation and supported by the L/C or original guarantee—not the L/C itself.
The exporter may put the entire export transaction in the hands of its bank and merely receive an agreed payment upon shipment or delivery of the goods, as called for in the L/C or terms of sale contract. A negotiable instrument arises as a result of the export/import transaction (but only after the goods have been delivered, the documents have been accepted by the L/C issuing bank as incompliance with the terms of L/C, and the acceptance or issuance of the pay obligation by the L/C issuing bank) in the hands of the exporter (unless otherwise specified by the terms of L/C), and is usually held by the exporter's negotiating bank, in compliance with the terms of the L/C or other form of guarantee, issuance or acceptance by the obligor (guarantor) and under authorization by the exporter (unless nominated otherwise in the L/C), and is sold ‘without recourse’ to the exporter. Care has to be taken to execute the appropriate documents to ensure the exporter and, as the case may be, exporter's bank have a viable negotiating instrument and a viable transfer of ownership of this receivable (obligation). The subsequent forfaiting transactions do not involve the exporter and generally may be carried on without the exporter having any knowledge of them.
This process has a number of benefits for both exporters and importers. For the exporter, it can grant credit (deferred payment terms) to foreign buyers without tying up cash flow or assuming all the risks of possible late payment or default. The exporter may also in this way protect against interest and currency rate movements during the credit period.
The importer deals only with its local bank. That bank is best positioned of any to assess the importer's credit risk and extract payment.
A ‘forfaiting transaction’ is defined, in this patent, to mean the transfer of ownership of a payment obligation (asset) in which the buyer forgoes any right of recourse to the exporter and subsequent holder or seller in the event that the obligor is unable to meet the payments required by the obligation (except in the case of fraud), where the payment obligation arises directly from a bank guarantee in any form given in the course of an export transaction and thereby resulting in a cross border trade receivable.
Of course, fraud may negate the subsequent transactions.
An example of a forfaiting transaction is as follows:
A letter of credit USD 1,000,000 is purchased at an interest rate of 8% p.a. for the deferred payment period of 360 days and that interest is discounted from the face at the time of purchase at a straight discount. The purchaser (possibly a forfaiter) pays USD 920,000 for the debt obligation and later sells it at 7% p.a. interest for duration of the deferred payment period, receiving USD 930,000. The intention of this transaction is to maximize the use of funds and generate revenue. USD 1,000,000 turned 40 times in a period of one year, assuming the same margins, could generate USD 400,000 in revenue. A counter party engaging in a forfaiting operation views this as a better value proposition rather than utilizing its capital to book assets on its balance sheet. If one were to assume the cost of funds of a traditional lender at 3% p.a. and the interest charged 8% p.a, this same transaction would generate USD 50,000 in revenue.
It is appreciated that forfaiting transactions can take place in connection with other credit enhancement products and or instruments as well as obligations supported by letters of credit. For instance, bills of exchange, drafts drawn under deferred payment (usance) letters of credit, Deferred payment claims with other forms of financial guarantees, drafts or promissory notes that are avalized, drafts and promissory notes with international ‘creditability’ that are naked, and any of these sometimes together with another form of credit enhancement—that is of course provided the payment obligation results directly from an export transaction.